I spent my Current Yield column this week discussing how the outcomes of the Detroit and Stockton bankruptcies are pretty uniformly bad for muni bond investors, since both of those cases upended the preferential treatment bondholders have traditionally received in Chapter 9 cases compared with other creditors. Instead, bondholders got the short end of the repayment stick in both cases, as public employees and pensions recovered a lot more of what each city owed them than bondholders did.

The outcome of the Detroit case was so bad that it prompted Matt Fabian of Municipal Market Advisors today to label the situation “all negative” for muni investors, particularly in the state of Michigan, adding that “takeaways for the municipal market from Detroit’s bankruptcy are uniformly negative.”

Pensions > Bonds: ”In the absence of legal precedents to the contrary, local unsecured GO bondholders, particularly those in MI, have to assume their position in the capital structure is subordinate to pensioners and indeed that of almost any other politically connected creditor,” Fabian writes. That’s some serious food for thought if you own muni bonds in Michigan.

OPEBs = Bonds: Fabian points out that unsecured bondholders weren’t treated better than OPEBs, which he calls “a complete change in thinking” for the muni market.

Bondholders can be bullied: After this case, Fabian sees “no reason why future debtor advisors would not similarly be able to harass municipal creditors into large losses.”

State as adversary, not partner: Fabian says Michigan “played a key role in steering losses onto” bondholders, and that lower-rated government bonds in Michigan “may no longer be suitable for traditional retail investors.”

Investor ambivalence: Fabian says investors have continued to buy Michigan bonds, and underwriters have continued to issue them, with little negative consequence to the state despite the unfavorable treatment of Detroit bondholders.

Fabian adds that Detroit still needs revenue growth to make its bankruptcy-exit plan work, and he calls the court case “undeniably a success for Detroit’s restructuring advisors, who followed a corporate-style, adversarial strategy that set creditor losses as its highest priority” and in doing so set a precedent for future municipal bankruptcy cases. He says the outcome may even prompt more federal scrutiny of profligate municipal governments, saying it even incrementally increases the risk that the federal government might revoke the tax-exempt status of municipal bonds.

As for Stockton, Fabian says the unfavorable treatment of certificates of participation in that case “should incrementally reduce the value and liquidity of [California] COPs.” He adds that COPs have been an important financing structure for California local governments, which are “likely to see their borrowing costs rise as a result.”

It’s not exactly a Charlie Gasparino versus Ron Insana Twitter fight, but the two biggest rating agencies are taking pretty different views on the impact of Detroit’s bankruptcy exit plan that a judge just confirmed today. S&P put out a statement saying the plan wouldn’t have any impact on S&P’s ratings of general obligation muni bonds, even though bondholders recovered a lot less money than expected compared to other creditors, particularly public pension recipients. By contrast, Moody’s Investors service just put out a statement saying the ruling “is generally credit negative for municipal investors because it reinforces favorable treatment of pension claims over other unsecured creditors. It also solidifies impairment of general obligation (GO) bonds.”

Moody’s says the plan is bad for GO bond investors in general, and Michigan GO bondholders in particular:

These creditors accepted impairments to their debt. In the absence of clear court opinions on the strength of each pledge, investors will therefore be more likely to negotiate with distressed cities in the future.

And more from Moody’s:

In confirming the plan, the court is sanctioning varying recovery rates amongst Detroit’s unsecured creditors. Reported recoveries for unsecured creditors range from an estimate of 14% for Certificates of Participation (COP) creditors to up to 82% for pension claims in real benefit terms. This disparate treatment of creditors was also a feature of the Stockton bankruptcy. These discrepancies leave investors with more questions than answers, but the emerging picture is one in which pensions have better recovery probabilities than debt in a Chapter 9 case, and municipalities exiting from bankruptcy likely retain responsibility for paying down large unfunded pension liabilities. We also note the confirmation does not affect existing settlements with Detroit creditors. Our ratings already reflect the recovery creditors will receive from those settlements,

Even though Detroit’s landmark municipal bankruptcy case – which just ended this afternoon – imposed an unusual degree of losses on bondholders relative to other types of creditors like pension funds and public employees, Standard & Poor’s says today that Detroit’s bankruptcy exit plan “has no impact on U.S. municipal general obligation ratings.” The comparatively poor repayment of bond debt in this case has sparked concerns about setting precedents in the fairly slim body of Chapter 9 case law. Apparently S&P doesn’t share those concerns.

“In the end, despite months of headlines and court battles, ultimately the outcome of the Detroit bankruptcy will not have an impact on our GO ratings,” said Standard & Poor’s credit analyst Jane Ridley in a statement.

Here’s more from S&P’s statement:

This view is based on our feeling that there was no precedent set that is widely applicable to GO debt, and that the forward-looking nature of our U.S. local government criteria gives us opportunities to identify and take into account such weaknesses before issuers reach the point of deciding who to pay and not pay, either via bankruptcy or default.

Standard & Poor’s has long said it expects to see pockets of stress, and outright distress, in U.S. local governments. “However, we believe our criteria allow us to identify and adjust ratings in distressed situations, and also to differentiate between different kinds of GO and GO-like pledges,” Ms. Ridley said.

Specifically, our U.S. local government GO criteria include forward-looking analysis and, when combined with rating caps, appropriately address the types of distress that are most likely to result in significant credit deterioration.

Multiplemediaoutlets are reporting that Judge Steven Rhodes has confirmed Detroit’s bankruptcy exit plan this afternoon, over 15 months after the city became the largest-ever municipal bankruptcy filing. Nathan Bomey, Matt Helms and Joe Guillen report for the Detroit Free Press:

Judge Steven Rhodes ruled that Detroit’s comprehensive restructuring plan is fair and feasible, providing the legal authority for the city to slash more than $7 billion in unsecured liabilities and reinvest $1.4 billion over 10 years in public services and blight removal.

With Rhodes’ decision, the city is expected to cut about 74% of its unsecured debt, freeing up significant cash to reinvest in services. The plan also projects potential cost savings through more efficient government operations that could increase the reinvestment plan to $1.7 billion.

The case is notable for imposing a surprising degree of losses on bondholders while simultaneously preserving a lot of the city’s pension obligations. It used to be that bondholders could expect preferential treatment in bankruptcies, but that’s been changing in some recent cases. Bank of America recently spelled out seven lessons investors should to take away from this case.

As two of the biggest municipal bankruptcies are winding down, they’re leaving behind precedents for future cases that seem to increasingly benefit retirees at the expense of bondholders. A judge recently confirmed Stockton, California’s bankruptcy-exit plan, while Detroit is set to emerge this month from the largest-ever Chapter 9 filing. Historically, bondholder claims on any bankrupt municipal government’s assets have been much stronger than pensioner claims, but that’s been shifting somewhat. Municipal bankruptcy filings remain rare, and each case tends to be unique, but both of these recent cases seem to weaken the traditional standing of bondholders relative to retirees and anyone receiving public benefits.

Alan Schankel of Janney Montgomery Scott looks at the issue today:

Pension funding or lack thereof has become an increasingly urgent issue for municipal bond investors and analysts. If events of fiscal stress dictate a showdown between bondholders and workers/retirees over who gets payment priority, the resolution remains unclear. Although the bankruptcy judge overseeing Stockton’s case ruled in October that pension obligations could be impaired with federal bankruptcy law trumping state employment law, the city chose not to impair pensions, despite significant haircuts to bondholders, in one instance providing for recovery on bonds secured by leases on a golf course and parks of only 1%. Final payout for retirees in Detroit is subject to a fair amount of actuarial uncertainty, but unlike bondholders, they will benefit from contributions made by not only the state, but also many philanthropic institutions.

Matt Fabian of Municipal Market Advisors has a similar take today:

In Stockton—and in Detroit if its bankruptcy plan is approved—pensions have been treated as senior to bonded debt, albeit to varying degrees. The cities’ decisions on how to handle pensions in chapter 9 appear to be based more on practical and political considerations than on a legal mandate to preserve pensions more fully than other creditors. Similarly, and maybe even more troubling, is the elevation of OPEB to the same standing as some debt obligations. Consequently, pensions should be considered a priority obligation and OPEBs should no longer be considered a “lesser” obligation. Both demand to be formally factored into traditional credit analyst debt metrics and rating decisions.

Schankel notes that at least special revenue bonds have emerged in good shape in these two cases:

One class of debt to emerge from Stockton and Detroit relatively unscathed are bonds secured by specific revenues such as water and sewer bonds. The revenues backing these bonds (water and sewer bills from ratepayers) were not diverted and continue to support bonds, with no defaults in the case of either city, although Detroit did make a voluntary tender offer on much of its water and sewer debt.

Detroit’s journey into municipal bankruptcy could come to an end next month, sixteen months after the city became the largest-ever municipality to file for Chapter 9 bankruptcy. With that milestone approaching, Bank of America Merrill Lynch municipal research strategists Philip Fischer, Yingchen Li, Emily Korot, and Celena Chan today look at how the landmark case has treated Detroit’s various creditors. BofA examines how the case might set precedents for future muni bankruptcies (given that they’re much more rare than corporate bankruptcies) and comes up with seven key take-aways for muni investors. From BofA:

A municipality’s full faith and credit tax pledge still doesn’t guarantee full recovery for bondholders. BofA notes that Detroit’s unlimited tax general obligation bondholders recovered just 74 cents on the dollar, roughly the rate at which the city was collecting its taxes, and it remains unknown whether those bondholders would have received more had they litigated further rather than settled.

Valuable assets are not always liquidated to enhance recoveries. BofA notes that Detroit’s museum collection was valued at over $8bn, but the city was still able to preserve that collection. Had the art museum been liquidated, BofA says, bondholders’ would likely have seen significantly higher recovery rates.

Settlements, rather than litigation, determine recoveries. In this case each major creditor settled, rather than litigated, its claim with the city, “effectively denying the establishment of case law to instruct future municipal bankruptcy filings,” BofA says.

For the most part, bond insurance did its job. Financially sound muni-bond insurers honored their commitment to pay principal and interest in this case, and BofA points out that they also “served as a unified representative whose motivation to maximize recoveries aligned with bondholders.”

Expect strategies that are more like poker than chess. From BofA: “The city bluffed and postured many times throughout its bankruptcy. For instance, while unlimited tax GO bondholders ultimately recovered $0.74 on the dollar, the city initially proposed a meager 15% recovery for those holders. Also, for Detroit Water and Sewer revenue debt, the city initially sought to impair bondholders by eliminating their call protection or reducing their coupon. In the end, the city purchased roughly $1.3bn of outstanding water and sewer debt at various prices, and left non-tendering bondholders unimpaired.”

Pensions tend to get better recoveries than bonds. BofA notes that city pensioners were minimally impaired, with cuts of no more than 4.5% and the elimination of annual COLA increases. In comparison, unlimited tax GO bondholders experienced 26% haircuts and limited tax GO bondholders experienced a 66% haircut. Pensions account for a seven times larger liability for the city, at $4bn, compared to $538mn in GO bonds.

Questions about the legal protections for certain types of “special revenues” may go unanswered. BofA says Detroit’s bankruptcy case still didn’t create “any clear, binding legal precedent on what characterizes special revenues in a municipal bankruptcy,” citing the special and presumably one-off treatment of Detroit’s water and sewer debt.

This week’s Barron’s cover story, by Jonathan R. Laing, examines the hugely complex task that is Detroit’s turnaround. The story looks at the city’s incipient revival, with the help of tech entrepreneurs and a seemingly rebounding downtown real-estate market. It also examines the city’s effort to emerge from bankruptcy protection, specifically the plan authored by Kevyn Orr, Detroit’s emergency financial manager, and how it would treat the city’s existing bondholders An excerpt:

The treatment of Detroit’s $18 billion in debt and other obligations under the plan varies all over the lot. The $5.4 billion in water and sewer bonds, backed by customer water-bill payments, will receive 100% of principal in new bonds. Similarly Detroit’s $479 million in general-obligation bonds, which have a call on the city’s annual state aid payments, will be paid off in full.

Holders of $530 million of G-O debt without the state intercept won’t all be so lucky. Most of the debt is insured, but $68 million of it is not. Those holders will get about 20 cents on the dollar.

The plan calls for even harsher treatment for holders of Detroit’s taxable $1.45 billion pension obligation certificates, issued in 2005 and 2006 to shore up its public-employee pension funds for uniformed and nonuniformed city workers. The city has sued to void the deals entirely (keeping the money, naturally) on the basis that the borrowings were illegal. Even if Detroit loses the case, certificate holders are likely to get less than 10 cents on the dollar. Even worse, where most of Detroit’s G-O debt is covered by strong bond insurers who are already covering the timely payment of interest and principal on the defaulting issues, the primary insurer of the POCs is Financial Guaranty Insurance Co., an outfit in run-off and constrained by its regulator, New York state, to pay out no more than 25 cents on each dollar of claims.

Rating agencies are weighing in today on Detroit’s latest bankruptcy exit plan, which the city filed with the court last Friday, and in a nutshell they’re saying bondholders could get screwed if the plan is approved, which could set a problematic precedent for other muni bondholders. First, here’s Fitch:

The plan not only classifies unlimited tax general obligation (ULTGO) bonds as ‘unsecured,’ but further degrades ULTGO value by giving other similarly classed ‘unsecured’ creditors preferential treatment, including unfunded pension and retiree healthcare liabilities. The city’s choice to treat ULTGO bonds as unsecured is particularly concerning, as they are backed by a separate property tax approved by the voters for the sole purpose of paying debt service on the bonds….

Fitch also finds troubling the city’s legal attempt to invalidate the certificate of participation (COP) debt, which would further skew the equitableness of the plan away from debtholders’ interests. The plan includes reducing COPs recovery to zero while remaining silent on whether or not the pension system, which benefited from the sale of the COPs, would return any of the borrowed assets. Fitch considers Detroit’s plan of adjustment to be hostile to GO bondholders. If this priority of creditors is upheld, Fitch expects that this disregard for the rights of bondholders will factor into higher borrowing costs for local issuers, and ultimately for local property taxpayers, in Michigan.

And here’s Moody’s:

The city’s workers and retirees are treated far better than GO and COP creditors. Pension recoveries range widely, from 66%-96% for already accrued benefits, but future benefits are cut much more substantially. Retiree health care benefits (OPEB) face much lower recoveries, but appear to be treated slightly better than GO creditors.

Litigation from GO creditors and other creditor groups is likely and the final court-approved plan could end looking much different from the city’s proposal. The possibility of cram down of the plan on creditors is possible.

Public pension plans are in the spotlight this week, and not in a good way.

First, a U.S. bankruptcy judge yesterday officially declared Detroit eligible to file for Chapter 9 bankruptcy protection, almost five months after the city initially filed its petition. Just as important, the judge said that federal bankruptcy law can trump Michigan’s constitutional protections afforded to public pensions, meaning Detroit’s pensions can be cut as part of the bankruptcy process. Here’s Moody’s weighing in today on the ruling:

The court held that the city may reduce accrued pension benefits because federal bankruptcy law, which allows for the impairment of contracts, will supersede the state constitutional language that prevents diminishment or impairment of earned benefits. Today’s ruling sets an important judicial precedent establishing that pension benefits are unsecured contractual claims in Michigan and could be cited as precedent in other jurisdictions. The ruling regarding pension benefits is akin to the Central Falls, RI bankruptcy in which employees took significant pension reductions. Ultimately, it sets the stage for the possible reduction of pensioner claims.

Separately, the Illinois General Assembly yesterday approved a $160 billion overhaul and rescue plan for the state’s beleaguered pension plan, which will cut benefits to retirees as well as current workers and try to fully fund the pension system over the next three decades. Here’s Alan Shankel, muni analyst at Janney Montgomery Scott:

The bi-partisan legislation could have an immediate impact on Illinois bond interest rates with a $350 million general obligation issue (A3/A-/A-) scheduled for competitive sale next week. The state’s pension funds have a combined funding ratio of about 40%, the lowest level of any state, with annual state pension contributions accounting for about 20% of annual budget expenditures.

These are but two battles in a widespread struggle between state and local governments and their pension debt obligations. The problem isn’t acute enough to take down large swaths of municipalities right away, but it’s an immense overhang that the broader muni market needs to address over time. What’s bad news for pensioners is often good news for bondholders, as any reduction in pension obligations leaves more money available to repay bondholders of any municipalities that find themselves in trouble, or in bankruptcy court. The Detroit ruling has the feel of corporate bankruptcy cases in which judge are commonly allowed to abrogate union contracts and impose losses on pensioners to enable bankrupt entities to more fully repay other creditors.

Obama administration economic officials are in Detroit today offering $300 million in combined government and private aid for the bankrupt city.

The government intends to remove red tape and otherwise streamline Motor City access to federal programs. It will also help the city tap private dollars. The aid will go to transportation and demolishing buildings, among other dire needs, but won’t be used toward Detroit’s $18.5 billion in debt obligations, according to news reports.

Don Graves, a deputy assistant secretary at the U.S. Treasury and executive director of President Barack Obama’s Council on Jobs and Competitiveness, will manage the federal response, according to a Detroit Free Press report.

The New York Times quotes Gene B. Sperling, the chief White House economic adviser,thusly: “There is nothing we can do to help on the bankruptcy; there is no bailout … However, we want to look at what could we do to help Detroit through existing resources and mobilization.”

Detroit’s bankruptcy was the largest ever for a municipality. Moody’s has called its restructuring unconventional and precedent-settingJeff Macke on Yahoo Finance writes that $300 million for Detroit, with many in its 700,000 population living in isolated danger, “is like dumping a cup full of water in Lake Michigan.” But it’s hard to sneer at $25 million from the Federal Emergency Management Agency to hire 150 firefighters and buy equipment to fight arson.

Chicago, meanwhile, has pension liabilities that are 678% of revenue, far exceeding Detroit’s ratio, according to a fresh report from Moody’s. Among 50 government entities with the most debt, pension liabilities as a percentage of revenue are also high in Jacksonville, Florida; Los Angeles, Houston and Dallas. For more on Chicago’s woes and Moody’s ranking of cities with outsized pension liabilities, see the U.S. News & World Report article “Report: Chicago’s Pension Woes Worse Than Detroit’s.”

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.